Manufacturing a Minsky Melt up.
Hyman Minsky the famous Austrian economist have written about Minsky meltdown which explains a sudden and dramatic drop in asset prices due to evaporation of liquidity in a high leverage environment which results into defaults and this precipitates a further cycle of drying liquidity and falling prices. For more understanding on Minsky Melt down read the following blog. (http://beyondboom.blogspot.com/2010/10/minsky-melt-down-by-janet-l-yellen.html)
We all are very familiar with the concept of Minsky melt down which we all witnessed in 2008. But in 2010 we are about to witness a diametrically opposite event which we call as Minsky melt up. We can define Minsky melt up as rise in asset prices due to increasing liquidity which will push the investment demand for asset. As the demand for assets goes up the prices starts increasing which further cause demand to go up. The speculation develops into a self fulfilling prophecy till the point where asset prices reach stratospheric level. At some point the ample liquidity which is pushing the price up dries down (due to central bank action, or due to default, due to higher supply of assets or people realizing the bubble) which creates a Minsky melt down.
Never Fight the Mother Fed
Global central banks have started QE II. The current round of quantitative easing is mostly in the form of buying long term treasury bonds. By creating demand for treasury the Fed helps in reducing long term interest rate in the economy since all interest rates are benchmarked to the treasury rates. The lower interest rates help banks, corporations and consume
• Banks borrows at lower interest rate from Fed and lends it at higher rates and repair their balance sheet.
• Corporation can borrow at lower cost and invest in assets generating income which improves employment
• Consumer can borrow at lower rates and consume more which also helps in improving employment.
But there is also a side effect on economy due to the presence for the investment demand for money. Lower interest rates also enable investor to take obscene amount of leverage at negligible cost and invest in assets with the hope of future prices increase. When this behavior is imitated across by all investors it develops into a bubble.
If Fed determines it is capable of pushing the prices of all assets up by printing enough money and pushing long term interest rates down. Therefore when Fed is easing (as it wants asset prices to go up) it is useless to bet against it.
The Wealth Effect
First impact of QE is the wealth effect. Fed believes that it can stimulate consumption by producing the wealth effect. When asset prices go up it creates wealth effect. US consumer which is currently deleveraging (repaying debt) will start re leveraging (taking more debt) if asset prices goes up and his loan to net worth ratio falls. If consumption goes up (on the back of higher leverage and not due to higher personal disposable income) the demand for goods and services will increases which will generate more employment.
If employment increase the demand for goods further increases (as people who are jobless will start earning and spending) which will in turn fuel the virtuous cycle of demand and employment.
There are two holes in this theory.
1) Even if the demand for goods increases in the US it creates employment in China as most of the US manufacturing facility has shifted to China. Therefore lower interest rates stimulates Chinese Economy
2) This consumption induced boom will only last as long as the asset prices goes up. Once the asset prices stops going up and starts to correct the people who have taken leverage to consume will find themselves into a situation where the loan they have taken is higher than the market value of asset which cause a repeat of sub prime crisis 2008.
The Fed is currently increasing the liquidity as it believes that it is wise enough to withdraw liquidity from the system in a just manner so that the asset prices can correct slowly and gradually once the economy reaches full employment.
The Fed fails to understand that human beings are not fully rational. Once the liquidity starts to reduce instead of seeing a gradual price correction the demand vanishes over night as no one wants to buy or hold an asset with falling prices. If everyone is sure that prices will go down in future they will either abstain or delay their buying (which results into demand vanishing overnight) and those who are holding the asset for price gains will become sellers (as they want to cash into their profits or avoid future losses). This phenomenon where demand vanishes suddenly and supply accentuates results into Minsky meltdown.
It should be noted that if economy starts to pick up the Fed had no option except to withdraw the liquidity as money multiplier starts to rise and since the monetary base is higher it creates inflation of hyper inflation. In order to combat inflation the fed will either reduce liquidity base or increase interest rates. This means that the current cycle is nothing more than a repeat of 2003 -2008 period where at first the liquidity increased which created a bubble and then when liquidity was withdrawn it created the crisis.
The only difference is that this time the government balance sheet and consumer balance sheet are in much more worse shape and this bubble is created on such massive scale on global level that its effect will be far more destructive than 2008. Let me explain you how.
Currency War
The second impact of Quantitative Easing is that since the supply of dollar increases, the value of US dollar falls compared to other currencies. This will negatively impact the exports of countries exporting their goods to US. To stimulate their exports they want to keep their currencies low to give them competitive advantage. This induces them to devalue their currency against other countries currency. But every country cannot devalue their currency at the same time. This will result into a currency devaluation war as any country which does not indulge in competitive devaluation will suffer by reducing exports and increasing imports. Today every country whether it’s US, EU, China or Japan is trying to stimulate its GDP growth rate by increasing exports to grow. But the problem is that all countries increase their exports at the same time.
To mitigate the impact of rising currency, central banks in those countries will be forced devalue their currency against dollar. This can be achieved by lowering the interest rates in the economy by quantitative easing.
The first impact of currency devaluation on countries (which under take QE to keep its currency value low) is run away asset prices. Asset prices will increase due to increasing investment demand for assets from rising domestic liquidity and increasing investment demand for assets from carry trade. This will increase the prices of assets till they reach stratospheric level from where they will have to crash.
Second impact of currency devaluation is that easy monetary policies will create more leverage in the economy. As money is easily available it will encourage people to take leverage and consume. Fed which is unable to convince the US consumer to take on more leverage to consume and stimulate US economy will end up in convincing consumer from other countries to take leverage and consume. A part of this consumption will go to the US as US corporate are increasingly getting transnational. This may increase profitability of some US corporation. (This may be a reason that the current earnings of major US corporations are rising despite of weak US economy as US corporations increasingly derive more profits from aboard than US.)
But this consumption demand will last as long as easy money is available and people are able to take leverage. Once consumer becomes over leveraged (like in US where inspite of easy policy of FED consumer are deleveraging) they have no option except to deleverage and the bubble is burst
Carry Trade Impact
The third impact of Quantitative easing is that since the short term interest rates in US and Japan are virtually zero, Investors can borrow insane amount of money and deploy them to buy assets in emerging market in search of profit. This phenomenon of borrowing at very negligible amount of interest and investing that at higher yield is known as carry trade. Carry trade will provide huge liquidly in emerging market which will result into currency and asset price appreciation and will ultimately inflate a bubble. Whenever this carry trade will be reversed it will cause a very painful bubble burst
Therefore the current QE in US will not only result into asset price bubble in US but across the world it will inflate asset prices and leverage. Therefore whenever this bubble burst it will not only cause an asset price deflation in US but across the globe.
Impact of QE and its repercussion
Today world is more integrated as every economy is linked to another economy by foreign capital flows. The global nature of foreign capital flows will create bubbles everywhere and they all will burst simultaneously when the global liquidity will be withdrawn. Therefore this current cycle of asset bubble is not domestic but global and its impactions will be grievous to investor in every part of the world.
Just imagine a scenario where there is a simultaneous fall in global stock prices, real estate prices, commodities. Global investors will found themselves in much worse conditions than they saw in US in 2008. There will be no safe heaven as even banks will be going burst due to bad lending decisions. We may find that the global economy will be in the same situation like Japan was in 1990 after real estate and stock market bubble busted and the country was push into depression. If this happens on global scale we can see world economy going into recession for years.
It will be better for the world economy if this bubble burst before reaching such epic proportion. That is the best hope I have, because if things continue to remain insane for longer than the pain caused by the bubble burst will be of epidemic proportion. The government which is already reeling under high debt ratios don’t have a single weapon left to fight such slow down.
The Coming Tsunami of Asset Bubble
The sub prime crisis originated in US, it snowballed into a banking crisis but was largely contained to developed world banking system. The impact on developing world was limited as the asset prices (house prices) in developing countries have not reached bubble valuation and the demand for consumption was much higher in the developing country which supported falling prices.
But off late the increase in asset prices is reaching alarming proportion. For example in china inflation has mostly occurred in land and commodities. Land prices have increased on average by more than ten times since 2003, 30 times in some hot coastal cities, and more than 100 times in the most speculative areas. It is reasonable to believe that China's land price is highest among all the major economies today, even though China's average wage is one tenth that of developed countries
Similarly if we look at real estate prices in India we can see that prices in cities like Bombay have become completely unaffordable to a vast majority of people. A 2BHK flat in suburbs of Bombay can cost anywhere above 1 crs which is around 10X an average persons after tax salary. Similarly the home prices in other cities like Ahmadabad, Pune, Indore have doubled since the lows of 2009 and increasingly becoming unaffordable.
As we have seen that since the investment demand for assets is very high the prices will keep on going up till there is ample liquidity and people believe that they will be able to sell their assets in the market. But ultimately the prices rise will reach unsustainable level and due to factors like decreasing liquidity it will turn into a seller’s market and prices will crash.
How irrational can price get?
In order to find an example to compare as to how irrational prices can get before they correct. I stumbled upon data from Japan. Since Japan has been an ultimate bubble where prices of real estate rose from 1980 -1989 and then crashed more than 90%. In most of the part of Japan the real estate prices are still 70% lower than their previous peak even after two decades have passed.
Prices were highest in Tokyo's Ginza district in 1989, with choice properties fetching over 100 million yen (approximately $1 million US dollars) per square meter ($93,000 per square foot). Prices were only marginally less in other large business districts of Tokyo. By 2004, prime "A" property in Tokyo's financial districts had slumped to less than 1 percent of its peak, and Tokyo's residential homes were less than a tenth of their peak, but still managed to be listed as the most expensive in the world until being surpassed in the late 2000s by Moscow and other cities. Tens of trillions of dollars worth were wiped out with the combined collapse of the Tokyo stock and real estate markets. Only in 2007 had property prices begun to rise; however, they began to fall in late 2008 due to the financial crisis.
If you look at the equity prices Japanese Index Nikkei made a high of 38957 on December 29th 1989 and fell to 7000 a fall of approximately 82%. Nikkei reached an astronomical valuation level and was trading at a high of 60 to 65 X price to earnings and has currently fallen to less than 10X.
Similarly Chinese Shanghai Index traded at all time high P/E of 54X before crashing 12X P/E in just a matter one year. Even more spectacular was the rise of valuation which rose from a level of 26X to 54X in just a matter of two years.
If we compare this to India, Sensex traded at an all time high P/E of 33X in 1992 after which it crashed to less than 10X. In last 12 years Nifty has never traded for more than 28X P/E. The current P/E of Nifty is around 26X which suggests that as per historical valuation we are very near to the peak.
But we are missing a very important point out here. Nifty constituent gets changed whenever the index is rebalanced. We can see that since January 2008 certain low P/E stocks have been replaced by high P/E stocks which are pushing the P/E for entire index upward.
Therefore I have calculated the true P/E of nifty (with current constituents) as on 8th January 2008 and 20th October 2010. We can see from the following table that Nifty was trading 27.27X earnings on 8th January 2008 while the current P/E ratio for nifty is 22.77X which means that there is a scope for further appreciation of another 20% on index if valuations will have to reach 8th January 2008 levels.
If we look at one more metrics I found to be very interesting is that the stocks trading above the p/e ratio of 30X and price to book ratio of 4X during different phase of market cycles.
As we can see from the table that during the January 2008 at the top 1340 companies trading in Nifty had market cap of more than 100 crs, 412 companies had p/e of more than 30X while 329 companies had p/e of more than 30 and price to book of more than 4 times.
When market crashed only 813 companies had a market cap of more than 100 crs, 61 companies had p/e of more than 30X while only 18 companies had a p/e of more than 30X and price to book of more than 4X
If we look at current ratio 1414 companies had market cap of more than 100 crs. (due to many new companies being listed and natural growth over last two years), 319 companies had p/e of more than 30X, while 163 companies had p/e of more than 30 and p/b of more than 4X this much lower than the market peak we saw in 2008.
This means that according to this metrics also we can see there is some scope for the market to go up as the valuation of overall market had not reached the 2008 levels. The index stocks have reached the previous highs on valuation metrics but where the broader market had become very expensive.
Valuations are not static and they change with changing circumstances. If there is ample liquidity and confidence in people valuations will expand to reflect that. Similarly if valuation will contract to represent retreating liquidity or falling confidence.
We have already seen that equity prices can trade at much higher valuation levels. Nikkei traded at 60 - 65X while China traded at 54X. Similarly it is not impossible that we can see Indian markets trading at astronomical valuations of 35 X or more (if global liquidity persists). If I assume that Indian markets can trade anywhere between 30X - 35X price to earning than Nifty can trade up to 7200 to 8000 levels.
One more thing about bubble is the more insane valuation goes, the harder it falls. I have pasted the below chart to give you an idea about the market bubbles. We can see that the first wave was the dot.com bubble which burst in March 2000. The second bubble was the financial crash which burst in 2008. If we look at the magnitude of this bubble we can see that the crash of 2008 was more painful than the crash of 2000.
Similarly the current wave which is going on may result into even more absurd valuation but when it cracks the pain will me much more than what it was in 2008.
We can see the similarity between these two charts. We can see how each wave is higher than the previous wave. Similarly the crash of each wave is more violent and painful than the crash of previous wave.
We have already seen that equity prices can trade at much higher valuation levels. Nikkei traded at 60 -80X while China traded at 54X. Similarly it is not impossible that we can see Indian markets trading at astronomical valuations of 35 X or more (if global liquidity persists). If I assume that Indian markets can trade anywhere between 30X - 35X price to earning than Nifty can trade up to 7200 to 8000 levels.
The question however is that whether this will happen. It all depends on global macroeconomic scenario. If the central banks continue with quantitative easing and global macro risk centers like Japanese sovereign debt bubble, China real estate bubble, Europe sovereign debt crisis and US housing remains dormant than valuations in Indian markets can move up sharply and lofty valuation of Nifty cannot be ruled out. But if any one of these risk centers activates than market may crash at anytime.
But this time is different
Since we have already seen Indian markets have some more room to go up, I am afraid that the valuation levels may reach a new high and may not be limited to the previous ceiling. If we look at the global liquidly, we can see that for next one year or so the liquidity flow from developed market to developing market will increase. This rise in liquidity will cause asset prices to move up and will ultimately create a bubble.
One very peculiar thing about bubbles is that every time they form, people are always convinced that this time is different. Whether we taken an example of the Japanese bubble, dot com bubble or subprime bubble people have rational that this thing will last but it never does
Similarly today we have full conviction that the current prices will last due to increased liquidity in the system. But just like past bubbles the current bubble will also burst suddenly and most of the investors will found themselves to be trapped.
Therefore I believe that an investor it is better to stay out of the market and watch the market getting irrational. Cause ultimately every bubble has to deflate and bigger the bubble, higher the pain it gives when it burst.
For a trader who has high risk appetite can buy the market at lower levels. I think in November market may correct a bit and reach 5750 -5800 levels. At that point in time a trader can buy the market with a stop loss of 5300 for a target of 6900 – 7200 on Nifty.
I will end this extremely long post of mine I authored over last few days with a quote of Jim Rohn “We must all suffer from one of two pains: the pain of discipline or the pain of regret. The difference is discipline weighs ounces while regret weighs tons."
